HOW BANKS CREATE MONEY 15
like the repayment of a loan - will reduce the
supply of money. The securities buyer witl pay
byihlque and Soth "securities" and "Demand
dlposits" (the latter being money) will decline
by the amount of the sale.
Prolits and liqulditY
The relative importance of the various asset
items on a trading bank's balance sheet is the
result of the banker's pursuit of two conflicting
goals. One goal is profits. Trading banks, like
iny other business,-are seeking P.tofrtj- To this
the bank is desirous of holding loans and
"nd
securities. These two items are the major earning assets of trading banks. On the_other hand,
a lrading bank must seek safety- For a bank,
safety liJs in liquidity - specifically_sucfr liquid
assets as cash.and excess reserves. Banks must
bg on guard for depositors' transforming their
currer,ideposits into cash. Similarly, the -possibility exists that rnore cheques yill P" cleared
against a bank than are cleared in its favour,
causing a net outflow of reserves. Bankers are
a ProPer balance between pruthus seeking
-profits.
The compromise that is
dence and
achieved detirmines the relative size of earning
assets as opposed to highly [quid assets.
suppose that if any bank becomes.able to in. cr6ase its loans as a result of acquiring excess
reserves, an amount equal to these excess reserves will be lqnt to one borrower, who will
write a cheque for the entire amount of the loan
and give it-to someone else, who deposits the
cheque in another bank. This assumption
merely means that we are assuming the worst
thing possible that can happen to any lending
bank - a cheque for the entire amount of the
loan is drawrr and cleared against it and in
favour of another bank.
The banking system's lending potential
To get the ball rolling, supPose that the Reserve
Bank buys a $100 government bond in the open
market from a private individual or business
firm. The seller bf ttre bond deposits the $100
cheque he receives in bank A, and this $100
constitutes an addition to the bank's reserves.
(We shall find in Chapter 16 that such bond
purchases by the central bank are a part of its
deliberate policy to increase the excess reserves
of trading banks and ultimately the supply of
money through bank lending.) Since we are
recording only changes in the balance sheets of
the various trading banks, bank A's balance
sheet now appears as follows, items (ar):
The banking $Ysterfi:
M ultiple-dePosit exPansion
Balance sheet: Trading Bank A
Thus fir we have discovered that a single bank
in a banking system can lend dollar for dollat
with its excess reseryes. Now what of the lending ability of all trading banks takea as a
group? Jrimping to our conclusions, we shall
nna ilat the trading bank system can lend, that
is, can create money, by a multiple of its excess
reserves. This multiple lending is accomplished
despite thefact that each bank in the system can
only lend dollar for dollar with its excess reseives. The immediate task is to uncover how
these seemingly paradoxical conclusions come
about.
To do this, it is necessary that we keep our
analysis as clear as possible. Therefore, we shall
rely upon three simplifying assumptions. First,
suppoie that the reserve ratio for all rrading
banks is 20 per cent. Second, assume initialy
that all banks are exactly meeting this 20 per
cent reserve requirement. No excess reserves
exist; all banks are "loaned up". Third, we shall
Liabilities and net
Assets
worth
Reserves
deposits $+ 100 (ar)
80 (ar) Loans
80 (a")
Current
-
+
-
$*
-+
100 (at)
80 (a")
80 (cr)
How much excess reserves does bank A now
have? It has acquired $100 in new res€rves, but
in the process it has also acquired $100 in new
current deposits. This means that 20 Per cent
of the new reserves must be earmarked as required reserves to offset the new deposits. In
ihort, $20 of the new res€rves will be required,
freeing the remaining $80 as excess reserves.
Remembering that a single trading bank, such
as bank A, can lend only an amount equal to
its excess reserves, we conclude that bank A
can lend a maximum of $80. When a loan for
this amount is negotiated, bank A's loans will
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